Sober strategy for the Vile decade

After the “Nice” decade of continuous expansion, Stuart Thomson of Ignis reckons we are in an equivalent period of growth recession in which a bond fund return of 3-4% will look attractive.

﻿Mervyn King, the governor of the Bank of England, described the 10 years up to 2007 as the “Nice” decade of Non-Inflationary Continuous Expansion. Now we’re in the “Vile” decade, says Stuart Thomson, the joint manager of the Ignis Absolute Return Government Bond fund.

The Vile decade is characterised by Volatile Inflation but with Limited prospects for sustained economic Expansion. Where Thomson departs from consensus is just how long this period will be. It has become customary to say there will be no interest rate rise in Britain until at least 2013. But he reckons it could be many more years than that.

“We are going to experience ultra-low rates for a great deal longer in the UK,” says Thomson, the chief economist of Ignis Asset Management, who co-manages the fund with Russ Oxley. “We are in a growth recession, where growth in the UK will average just 1-1.5% a year over a decade.”

That growth recession is not confined to the heavily indebted developed world. Thomson says even China will suffer a growth recession – which means it will grow at more like 6% a year rather than 9%. (Collinson continues below)

Inflation is the enemy of bond fund managers, and there are concerns, above all in Germany, that when central banks print money, then inflation follows as surely as night follows day. But as households deleverage and governments introduce austerity packages, there is simply no demand in the economy to pump up prices. For policymakers, the constant problem will not be inflation, but deflation.

“The balance sheet of the private sector is deleveraging,” says Thomson. “Corporates are not spending. Governments are cutting budget deficits. Central banks have to expand their balance sheets to drive rates to low enough levels to encourage the corporate sector to reduce their savings and invest instead. You can run QE [quantitative easing] for quite a long time in this environment.”

Thomson recalls the savings and loans crisis in America at the end of the 1980s. The industry represented only 15% of American GDP, but it took three years for balance sheets to be restored. During that period (notable for a jobless recovery) interest rates fell from 9% to 3%. Today’s balance sheet crisis is global, and this time it’s going to take a lot longer to get through it. Hence the possibility of ultra-low interest rates extending into the future, Japanese style.

“At some point towards the end of the decade, when consumers have restored their balance sheets, banks have recapitalised and government deficits are down, there will be an inflation risk, but that will come at the end of this period, not now,” says Thomson.

But hold on. Isn’t Angela Merkel, the German chancellor, rather against QE in any shape or form? Thomson isn’t so sure. Despite what the ECB rules may or may not say, he says the bank is already expanding its balance sheet significantly. “The question is if it is doing enough. QE only works when it is big and awesome. That’s what we have learned from the mistakes of the Bank of Japan. And that’s why Europe is going into recession again next year.”

Even the German economy will struggle to show any growth, he says. He expects that as the peripheral eurozone countries slip deeper into recession, joined by France and Belgium, German exports will fall steeply.

But Thomson’s central view is that the euro will hold together, that closer political union is more likely than a break-up, with Germany dictating the terms. A break-up of the euro would, he says, be a “Credit-Anstalt” moment. Credit-Anstalt was the Austrian bank whose default in 1931 triggered bank collapses around the globe.

But with the euro still in place, Italy, Spain and Greece will not be able to grow their way out of trouble. So how do they deal with their debts? Greece has already done it, with its 50% – although still being negotiated – ’haircut’. Thomson argues that Italy will also have to impose a haircut on bond investors, probably about 15%.

This analysis leads to some pretty obvious portfolio choices. Thomson doesn’t hold any of the bonds of periphery countries, although he’s sanguine about Germany, despite that poor bund auction last week and the subsequent rise in bund yields. Over the next 12 months he expects France and Austria to lose their AAA government bond ratings, leaving only nine sovereigns in the top tier – including four in Scandinavia and, somewhat remarkably, Britain.

Scandinavia is attractive, but its markets are narrow and illiquid. “Our safe haven is US Treasuries,” says Thomson. “It is still the world’s reserve currency, and the deepest and most liquid bond market in the world. US growth may be anaemic, but it is still the best horse in the glue factory.”

﻿”US growth may be anaemic, but it is still the best horse in the glue factory”

But Thomson is not your standard bond fund manager. While most bond funds follow a duration-based approach, Ignis focuses on forward rates, which it says exposes significant price anomalies that can be exploited. The fund can take both long and short positions in bonds and currencies, although it hedges out extreme risks.

It was launched in March, so there is not much of a track record yet, but its A shares have achieved a return of 4.3% so far. That’s no better than the typical gilt fund, but Thomson insists: “This fund has been designed to work across the cycle. It will benefit in both good and bad economic times.”

Short positions are currently around currencies, with Thomson expecting the peculiar strength of the euro to subside in coming months. Governments that held euros as a reserve currency are stepping away, while Europe’s more globally orientated banks, which have effectively repatriated euros during the crisis, will reach the end of that process.

If Thomson is right, investors will enjoy returns of 3-4% a year from investing in his bond fund, and, what’s more, it will be uncorrelated with other asset classes. If we really are in the middle of a Vile decade, sober returns like that will start looking very attractive.